1. Demonetisation is a big gamble; here’s why

Demonetisation is a big gamble; here’s why

Removal of a malignant tissue involves a painful surgery; and the recent demonetisation of R500 and R1,000 notes is no exception.

By: | Published: November 21, 2016 6:13 AM
money-l-reu The measure will have short-term as well as long-and medium-term impact. In the short run-which is all that matters for most people, the lengthening queues outside ATMs and banks is only the beginning of the problem. (Source: Reuters)

Removal of a malignant tissue involves a painful surgery; and the recent demonetisation of R500 and R1,000 notes is no exception. The denotification of currency of these denominations is indeed a big gamble. If it succeeds it would be a reform, much more significant than the abolition of the licence permit raj in 1991; or any other reform undertaken by any government since independence. If it fails, the economy might plunge in to a recession which might be difficult to shake-off.

The measure will have short-term as well as long-and medium-term impact. In the short run-which is all that matters for most people, the lengthening queues outside ATMs and banks is only the beginning of the problem. Hopefully, people will be able to deposit, withdraw and exchange their old notes for new ones before the situation gets out of hand.

A much more serious problem, however, is the one that confronts the informal as well as certain sections of the formal economy that run largely on cash–namely retail, agriculture, gems and jewellery, real estate, SMEs, etc. For these segments, demonetisation is a money supply shock because they have suddenly lost their medium of exchange.

As any professor taking an Economics 101 course will vouch, wiping out 86% of the money supply in a sudden strike, however precise, is bound to make money scarce, raise private interest rates, and contract demand for both private consumption and investment. Two important components of aggregate demand will, thus, immediately register a contraction. This will in turn lead to lower prices, lower GDP, increase in unemployment and a recession. The vital question facing the nation today is whether improvement in money supply subsequently will lift these sectors out of recession. There are some economists who feel that instead the recession might spill over into other sectors because all of them are dynamically interlinked to one another. In fact, that is what happened in the US, when sub-prime mortgage crisis broke out in 2008.

Regardless, one immediate consequence of demonetisation will be the transfer of resources from private hands to the government. Since not all the demonetised notes of R14.83 lakh are likely to find their way back to banks, some extinction of RBI’s liability will take place. When demonetisation last took place in 1978, about 20% of the liability of the RBI got extinguished. The economy at that time was much smaller, and the demonetisation of high value currency affected very few people. This time the game is very different; the income-tax department has more sophisticated technology and analytical techniques to trace out transactions carried out by tax evaders. As a consequence, many people may prefer to take a direct monetary hit rather than surrender their high denomination cash hoardings to banks and expose themselves to prosecution. As they may fear that they may not be able to explain how they acquired so much cash in the first instance. If this happens to 50% of the cash hoardings, the government will be richer by R7.41 lakh crore, which is currently about a year’s collection from income-tax. The government may spend this on building infrastructure, reducing its debt to the public, or improving the position of its fiscal deficit.

Simultaneously, the banks will be flush with funds. They will be in a better position to absorb the NPAs generated in the past and reduce lending rates for their customers. Whether managers will acquire the courage to actually take risks and lend is, however, a totally different issue.

The effect on income-tax revenues will in all likelihood be mixed bag. Since with the new technologies available, it will be easier for the department to track transactions of citizens. Existing taxpayers, too, could be expected to report higher incomes in future. However if a recession does set in, these positive effects may be offset by taxpayers genuinely earning lower incomes as result of which they may pay lower tax. Much would, therefore, depend on how the positive and negative effects of demonetisation balance out in future.

In the medium and long run, however, if the government’s gamble pays off, the nation will reap rich dividends. Sources of terrorist funding and all kinds of other socially harmful activity will dry up. India will emerge as a modern economy in which cash plays an insignificant role. Prices will come under control. Banks will be in a much better condition to lend. Government finances will be much healthier than what they are now. Equity and bond markets might flourish, and the country’s sovereign ratings too will improve.

Much more, however, needs to be done to ensure that this outcome is achieved. The I-T department will have an important role to play. Its new strategy could perhaps aim at making the cost of evasion as high as possible; and simultaneously, the cost of compliance as low as possible. It may want to depend much more on techniques available in modern information technology–such as data warehousing and analytics–rather than on individual discretion, for selection and investigation of scrutiny cases. In order to strengthen the tax base and attract and retain new taxpayers, it may find it fruitful to enquire into taxpayer needs and see how best these could be satisfied. One way surely would be to simplify and demystify complex provisions so that ordinary taxpayers can comply with them without incurring extra-ordinarily high compliance costs.

Hopefully all this, along with reduction in tax rates, will bring some sunshine in our winter of discontent!

The author was chief commissioner of income-tax and ombudsman to the I-T department, Mumbai

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  1. S
    Dec 11, 2016 at 10:03 pm
    If this step works out and normalcy returns in the next 3-6 months. Then the govt will be lot more emboldened to take a few more drastic steps to weed out some corrupt enies. This time the target will be the ultra rich & corrupt people.That will reduce the black market activities and hence more open digital business activities.The more digital India will increase tax receipts and strengthen India.In the long run it will work out fine. A Modern India will come out of this sacrifice.
    1. J
      Nov 22, 2016 at 10:03 am
      Government gaining 7.41 Lakh Crore seems a huge exaggeration. I heard the report saying that the bank has already received 5.5 Lakh crore (by 18th November) 'white' money from the people. There was at the end of September, the Bank had it seems around 4 Lakh crore in hand. so it already amounts to 9.5 Lakh crore. There is only 5.33 Lakh crore left. I do not think Government will get more than 3 Lakh crore.
      1. A
        Nov 22, 2016 at 8:22 am
        This scheme is daylight robbery. Many households keep significany cash at home rather than bank for expenses. All this money will now be transferred to the bank hopefully. Govt has given time only till december. The bank will exchange old notes for new . so how can the bank profit?. Also many household may not be abke to deposit as banks do not have enough cash to exchange. It will take them 6 months to print all this cash. Even if banks liability reduces with customers deposit legally they cannot spend on reducing their npa or govt is allowed to spend on infrastructure. Essentially there is more pain than gain
        1. S
          Shrinivasa Kamath
          Nov 22, 2016 at 1:19 pm
          It said that in 1978 only 2% of the money in circulation was demonitised in large currency notes of Rs.1000 and above. If that has extinguished 20% of liabilities of RBI at that time, now it should be much more since 86% of value of currency in circulation is demonitised. Central government's move has been critcised world over as bad move which may cripple economy.
          1. R
            Ramendra ghosh
            Nov 22, 2016 at 3:46 am
            With so much of positivity , the media i feel has an immense role to play in achieving the designated goal. Instead of petty bickering, let us( all Indian) for once keep the Nation before all.
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